The transformation of uncertainty

A few years ago, a central bank governor of one of the OECD countries told a close adviser that he preferred to postpone a decision to modify the official benchmark rate because uncertainty was bound to decline. The advisor responded that the next monetary policy meeting would surely be accompanied by a whole new batch of surprises.

This anecdote clearly illustrates how the markets and the economy have reacted since the beginning of the year to various sources of uncertainty, which are inherent, at least in part, in a market economy. We must constantly ask ourselves where the next bit of bad news might spring from. We should also keep in mind that better visibility in one area is simply a reminder to search for other sources of uncertainty elsewhere.

Earlier this year, investors were mainly focused on the Federal Reserve’s monetary policy and the impact of the US fiscal stimulus on interest rates. Turmoil swept the markets in early February when inflation proved to be higher than expected, reviving fears of a more aggressive round of monetary tightening. These fears did not spare long-term rates, which had been trending upwards since September 2017, thanks to the prospects of tax cuts that were finally announced towards the end of last year. Beginning in the spring, the focus gradually shifted to fears of a trade war, triggering an easing of US long-term rates and a flattening of the yield curve. This dynamic momentum was given broad media coverage, especially since past recessions were preceded by an inversion of the yield curve, when long-term rates drop below short-term rates.

It is much harder to come to grips with the uncertainty arising from US protectionist threats rather than from monetary policy (even though “real” uncertainty, in the strict sense of the term, pertains to economic trends and not the central bank’s reactions) or from the swelling of the US public deficit. We have statistical estimates to guide us on the deficit’s impact on interest rates. As to monetary policy, the central banks have opted for forward guidance, providing clear, proactive communications that aim to avoid surprises. Plus, the markets have a fairly good understanding of how central banks react to growth and inflation trends.

For trade wars, in contrast, the uncertainty stems from economic policy. Consequently, any changes are very hard to predict, especially since psychology plays such an important role. How can you anticipate trends in a power struggle or battle of wills? How far will the escalation go once retaliatory measures are introduced? This is a problem not only for companies located in the country targeted by US measures, but also for those located in the US. The latest report by the Institute of Supply Management, the institution that publishes the invaluable ISM indicator, covers the concerns of a variety of sectors ranging from capital goods to electrical appliances, food products, beverages & cigarettes, metal goods, machinery and the paper industry. The diversity of sectors involved illustrates the extent to which the organisation of international supply chains creates feedback loops: tariffs aimed at China, for example, end up affecting the subsidiaries of western companies active in China, notably American firms, and the ricochet effect drives up import prices and domestic producer prices in the United States. Corporate psychology is even more important for investment. A cold trade war of endless threats and counter-threats would inevitably have a negative impact on investment. It would also erode household confidence, resulting in a severe slowdown in growth.